What is a Stretch Out IRA?
Because of the opportunity for extraordinary growth, if you invest
money in an IRA and find it is not needed for your retirement, you will
probably be motivated to take the smallest allowable distributions from
it during your lifetime. By leaving the IRA as intact as possible, over
the years you may build up a substantial asset that will provide financial
security for both you and your heirs. With careful planning, each of
your beneficiaries can also use the same strategy by keeping his or
her share in a tax-deferred environment while receiving lifetime distributions.
This strategy of using an IRA to build wealth for future generations
is called a stretch out IRA.
Before explaining how a stretch out IRA works, some background information
would be useful. IRAs were created as a way to encourage people to save
for their retirement. The rules regulating IRAs are complex, but in
simple terms, they allow you to make tax-deductible contributions to
a retirement account that is not taxed until you withdraw the funds.
People dislike taxes, and the lure of a tax deduction for contributions
and tax-deferment on growth has proved to be irresistible. Many people,
particularly the wealthy, have contributed the maximum amounts allowed
by law into their retirement plans.
As investments, IRAs have generally done very well. Although the value
of stocks, real estate, and other assets may fluctuate wildly from day-to-day,
over the course of several decades, investment returns are more predicable.
For example, over the last 50 years the stock market as a whole has
had an annual return of slightly more than 10%. The combination of double
digit appreciation compounding in a tax-deferred environment is a financially
potent mixture. Without taxes, a retirement account earning a 10% annual
return will double every 7.2 years. Over a long period of time, the
growth potential is remarkable.
Consider the following table that compares the value of an initial investment
of $25,000 growing by 10% a year without being taxed against the same
investment subject to a income tax of 30%. After a ten year period the
differences start to show. The untaxed account has grown to around $65,000,
about 25% greater than the taxed account. After another twenty years,
the results become much clearer. The untaxed account is worth almost
$271,000, double the value of the taxed account. At the 40 year mark,
the difference is profound. The initial investment of $25,000 has grown
to over $1.1 million, while the taxed account is less than one-third
of that value.
COMPOUND GROWTH WITH
AND WITHOUT TAXATION
STARTING WITH AN INITIAL INVESTMENT OF $25,000 |
| Year |
10% Annual Growth with 30% Income
Tax |
10% Annual Growth Without Income
Tax |
Year |
10% Annual Growth with 30% Income
Tax |
10% Annual Growth Without Income
Tax |
| 5 |
$35,064 |
$40,263 |
30 |
$190,306 |
$436,235 |
| 10 |
$49,179 |
$64,844 |
35 |
$266,915 |
$702,561 |
| 15 |
$68,976 |
$104,431 |
40 |
$374,361 |
$1,131,481 |
| 20 |
$68,976 |
$168,187 |
45 |
$525,061 |
$1,822,262 |
| 25 |
$135,686 |
$270,868 |
50 |
$736,426 |
$2,934,771 |
Because of the opportunity for extraordinary growth,
if the money invested in an IRA is not needed for your
retirement, you will probably be motivated to take the
smallest allowable distributions from it during your
lifetime. By leaving the IRA as intact as possible,
over the years you will build up a substantial asset
that will provide financial security for both you and
your heirs. With careful planning, each of your beneficiaries
can also use the same strategy by keeping his or her
share in a tax-deferred environment while receiving
lifetime distributions. This strategy of using an IRA
to build wealth for future generations is called a stretch
out IRA.
The cumulative amount of distributions from a stretch
out IRA is mind-boggling. For example, a beneficiary
who receives $100,000 at age 30 might over the course
of a 52 year life expectancy receive distributions of
more than $2.75 million. The following table was taken
from a booklet published by The Wealth Advisory Group.
It shows the total income that might be paid out to
a beneficiary based on a number of different ages and
starting amounts. Although I haven't independently verified
the calculations, I have no reason to doubt their accuracy.
| TOTAL INCOME OVER
A BENEFICIARY'S LIFE EXPECTANCY |
| Age |
Life Expectancy |
Beginning Amount
$50,000
|
Beginning Amount
$100,000
|
Beginning Amount
$500,000
|
Beginning Amount
$1,000,000 |
| 5 |
61.9 Years |
$2,940,820 |
$5,881,640 |
$29,408,198 |
$58,816,396 |
| 10 |
52.2 Years |
$1,378,197 |
$2,756,394 |
$13,781,972 |
$27,563,944 |
| 15 |
42.5 Years |
$664,728 |
$1,329,456 |
$6,647,280 |
$13,294,560 |
| 20 |
33.1 Years |
$339,236 |
$678,471 |
$3,392,357 |
$6,784,714 |
| 25 |
24.2 Years |
$186,916 |
$373,832 |
$1,869,159 |
$3,738,318 |
Although the concept of a stretch
IRA is simple, analyzing your situation and carrying out
the details can be complicated. One problem you may have
to overcome is finding the liquidity to pay federal estate
taxes without having to use the IRA. Because of the growth
potential of a stretch out IRA sometimes its value will
represent a significant portion of your estate. Generally,
this problem is best handled by holding life insurance
in an irrevocable trust. This creates another source of
funds that becomes available upon your death and is not
subject to the estate tax.
The second problem is the type of retirement accounts
you have. Throughout this article I have used the term
IRA exclusively and have not referred to other types of
qualified retirement plans (QRPs) such as 401(k)s. I have
done this for several reasons. One reason is that it is
awkward to write (and read) IRA/QRP every time I want
to refer to a retirement plan. The other reason is that
the stretch out IRA strategy can be carried out with virtually
every IRA, while it is sometimes not possible with a QRP.
This is because the plan administrator of a QRP may not
be willing to administer a plan for your heirs that may
go on for up to 60 years. The solution to this problem
is to have someone analyze your QRP and, if it is not
stretch-out-IRA-friendly, make arrangements to have it
rolled over into an IRA at some point in the future.
The third problem is making the proper beneficiary designations
on your IRA. Although the new proposed regulations released
last year have simplified this process, it is still critical
to carefully name your beneficiaries. The wrong choices
can defeat the entire stretch out IRA strategy and force
its distribution over a relatively short period of time.
The fourth set of problems is coordinating your stretch
out IRA with your estate plan. Some of the issues are
subtle, such as deciding whether the beneficiary of a
stretch out IRA will be responsible for his or her share
of taxes and administrative costs or whether the gift
will pass free and clear of those expenses. Again, the
goal is trying to keep the stretch out IRA as intact as
possible.
Another estate planning issue is control and protection.
Sometimes it makes sense to put the stretch out IRA in
trust for the beneficiary instead of making an outright
distribution. This can serve several purposes. If desired,
the beneficiary can be forced to take distributions over
his or her lifetime instead of having the option to withdraw
all of the IRA funds at once. This restriction preserves
the stretch out IRA for the beneficiary and often reflects
the fact that the beneficiary has received with the stretch
out IRA other inherited property under more liberal distribution
terms. Keeping the stretch out IRA in trust also makes
it possible to provide the beneficiary with creditor and
remarriage protection. This protection is lost when the
beneficiary receives an outright gift.
Although the concept of a stretch IRA is simple,you should analyze
your situation carefully before deciding on a stretch out IRA. It is
strongly recommended that you seek advice from a professional financial
consultant.
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